What Is a 1035 Exchange?
A 1035 exchange is a provision in the U.S. tax code (Section 1035) that allows you to transfer the cash value from one life insurance policy or annuity to another without triggering taxable gains. Named after its section in the Internal Revenue Code, it's sometimes called a "tax-free exchange" or "like-kind exchange" for insurance products.
The key benefit: if your existing policy has accumulated gains above what you paid in premiums, you'd normally owe taxes on those gains when you surrender the policy. A 1035 exchange lets you transfer the full value—including gains—to a new policy without paying taxes now.
How a 1035 Exchange Works
Old Policy
Life Insurance
or Annuity
$100,000
cash value
TAX-FREE
Direct Transfer
New Policy
LTC Hybrid
Life + LTC
$400,000
LTC benefits
The Tax Advantage
Why It Matters for LTC Planning
The 1035 exchange is particularly powerful for long-term care planning because many people have existing life insurance or annuity policies that have completed their original purpose or are underperforming. Rather than surrendering these policies and paying taxes on the gains, they can exchange them directly into asset-based LTC products—life + LTC hybrids or annuity + LTC hybrids.
Common Scenarios for 1035 Exchanges
- •Orphaned whole life policy: Purchased decades ago for income replacement when you had young children—who are now adults
- •Underperforming universal life: A policy that hasn't met original projections and may be at risk of lapsing
- •Low-yield annuity: An old fixed annuity earning less than current rates, with built-up gains that would be taxable on surrender
- •Duplicate coverage: Multiple life insurance policies when one would suffice for current needs
- •Business policy no longer needed: Coverage from a business you've sold or closed
In each case, the 1035 exchange lets you redirect assets that aren't serving you well into LTC protection that provides leverage, death benefit, and liquidity—all while deferring taxes indefinitely.
The Rules You Must Follow
To qualify for tax-free treatment, a 1035 exchange must follow specific IRS rules. Violating any of these can disqualify the exchange and trigger immediate taxation.
Direct Transfer Required
Funds must transfer directly from the old insurance company to the new insurance company. If you receive a check and then pay the new premium yourself, it's not a 1035 exchange—it's a surrender and purchase, and you'll owe taxes on any gains.
Same Owner Required
The owner of the new policy must be the same as the owner of the old policy. You cannot use a 1035 exchange to transfer ownership to a trust, spouse, or anyone else. (You can change beneficiaries, but not the owner.)
Same Insured (for Life Insurance)
When exchanging life insurance for another life insurance policy or hybrid, the insured person must remain the same. You can't exchange a policy insuring yourself for one insuring your spouse.
No Cash to You
If any cash comes to you during the exchange (other than through a separate transaction), it can disqualify the exchange or create partial taxability. The full value must transfer directly.
No Loan Boot
If your old policy has outstanding loans, the loan amount may be treated as taxable 'boot.' This doesn't disqualify the exchange but can create a tax bill on the loan portion.
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What Can Be Exchanged Into What
The IRS allows certain exchanges but not others. Here's what's permitted:
Allowed 1035 Exchanges
Life Insurance → Life Insurance
Including life + LTC hybrid products
Life Insurance → Annuity
Including annuity + LTC hybrid products
Annuity → Annuity
Including annuity + LTC hybrid products
Annuity → Life Insurance
Not permitted under Section 1035
Notice that annuities can only go "sideways" to other annuities or "forward" from life insurance—you can't go from an annuity to a pure life insurance product. This is why annuity + LTC hybrids are the destination for annuity exchanges, while life insurance can go to either type of hybrid.
Products That Can Be Exchanged
✓ Can Exchange
- • Whole life insurance
- • Universal life insurance
- • Variable universal life
- • Fixed annuities
- • Variable annuities
- • Indexed annuities
✗ Cannot Exchange
- • Term life insurance (no cash value)
- • CDs or savings accounts (not insurance)
- • 401(k) or IRA funds (different rules)
- • Health insurance
- • Disability insurance
The Process Step by Step
Here's what a typical 1035 exchange looks like from start to finish:
Gather Information on Existing Policy
Collect current statements showing cash value, surrender value, cost basis, and any outstanding loans.
- •Request an "in-force illustration" from current carrier
- •Note any surrender charges that would apply
- •Verify ownership and insured details
Apply for the New Policy
Submit an application for the LTC hybrid product you're exchanging into. This includes medical underwriting.
- •Complete the application with health questions
- •Undergo any required medical exams or phone interviews
- •Wait for underwriting decision (typically 4–8 weeks)
Receive Approval
Once approved, the new carrier issues a policy offer with the terms based on your health classification.
- •Review the policy details and benefits
- •Confirm the premium/deposit amount matches expectations
- •Accept the policy offer
Complete 1035 Exchange Paperwork
Sign the 1035 exchange forms that authorize the direct transfer from old carrier to new carrier.
- •Both carriers have specific forms for 1035 exchanges
- •Forms must specify this is a Section 1035 exchange
- •Your advisor coordinates between both companies
Funds Transfer
The old carrier surrenders your policy and sends the cash value directly to the new carrier.
- •This typically takes 2–4 weeks after paperwork is complete
- •You should NOT receive a check—it goes carrier to carrier
- •Old policy terminates once funds are released
New Policy Issues
The new carrier applies the transferred funds and issues your new LTC hybrid policy.
- •You receive the new policy documents
- •Coverage is effective from the issue date
- •Update your beneficiary designations as needed
Timeline Expectations
Common Pitfalls to Avoid
Pitfall #1: Taking a Check Yourself
If you surrender your old policy and receive a check—even if you immediately use it to buy the new policy—it's not a 1035 exchange. You'll owe taxes on the gains. The transfer must be direct, carrier to carrier.
Pitfall #2: Ignoring Outstanding Loans
If your old policy has a loan, that loan amount may be treated as taxable income when you exchange. You might want to repay the loan before the exchange—or at least understand the tax implications before proceeding.
Pitfall #3: Not Checking Surrender Charges
Many policies have surrender charges that decrease over time. If you exchange during the surrender charge period, you'll lose that percentage of your cash value. Sometimes waiting a year or two saves thousands.
Pitfall #4: Assuming You'll Qualify for the New Policy
Apply for the new policy first, before initiating the exchange. If you surrender your old policy and then get declined for the new one, you'll have triggered taxes with nowhere to put the funds. Always get approved before exchanging.
Pitfall #5: Forgetting to Evaluate the Old Policy's Value
Not every old policy should be exchanged. Some whole life policies have valuable guarantees, dividend potential, or other features worth keeping. Make sure you're actually better off with the exchange, not just different.
Real-World Examples
Here are three typical 1035 exchange scenarios:
Example 1: Whole Life to Life+LTC Hybrid
62-year-old with policy purchased for income replacement 25 years ago
Before Exchange
Whole life policy from 1999
Cash value: $85,000
Cost basis: $52,000
Taxable gain: $33,000
Death benefit: $150,000
After Exchange
Life + LTC hybrid policy
LTC benefit pool: $340,000
Death benefit: $85,000
Surrender value: $85,000
Tax paid: $0
$33,000 in gains transferred tax-free. Same dollars now provide 4x leverage for LTC.
Example 2: Fixed Annuity to Annuity+LTC Hybrid
67-year-old with annuity earning below-market rates
Before Exchange
Fixed annuity from 2012
Accumulation value: $125,000
Cost basis: $100,000
Taxable gain: $25,000
Interest rate: 2.3%
After Exchange
Annuity + LTC hybrid
LTC benefit pool: $312,500
Accumulation continues
Death benefit: account value
Tax paid: $0
Same $125,000 now provides $312,500 in LTC protection plus continued accumulation.
Example 3: Universal Life to Life+LTC Hybrid
58-year-old couple with underperforming UL policy
Before Exchange
Universal life from 2005
Cash value: $62,000
Original projections: $95,000
At risk of lapsing if rates stay low
Increasing cost of insurance
After Exchange
Life + LTC hybrid policy
LTC benefit pool: $248,000
Death benefit: $62,000 (guaranteed)
Premiums: paid-up (no more due)
No lapse risk
Escaped a struggling policy. Locked in guaranteed benefits with LTC protection.
Is a 1035 Exchange Right for You?
A 1035 exchange makes sense when:
Good Candidates
- •You have an old policy that's completed its original purpose
- •Your policy has significant taxable gains
- •You need LTC coverage and have assets to reposition
- •Your current policy is underperforming or at risk
- •You're healthy enough to qualify for new coverage
May Not Be Right If...
- •You still need your current death benefit for its original purpose
- •Your policy has valuable guarantees you'd lose
- •You have significant outstanding loans
- •High surrender charges would eat into your value
- •Health issues may prevent qualifying for new coverage
The Bottom Line
A 1035 exchange is a powerful tool for turning existing life insurance or annuity value into LTC protection without triggering taxes. But it requires careful evaluation of your current policy, your health, and your goals. The best approach is to work with an experienced specialist who can analyze whether an exchange truly improves your situation—and handle the paperwork correctly.
Frequently Asked Questions
About the Author
Brian Thompson
LTC Insurance Specialist
Brian has spent over 30 years helping families navigate long-term care planning. As an independent broker licensed in 48 states, he specializes in asset-based LTC strategies that keep your money working for you—no matter what happens.